Fed Playing Delicate Rate Game to Sway Consumers

The summer swoon in stock prices may be just what the doctor ordered - Dr. Alan Greenspan, that is.

By raising interest rates a dose at a time, with another tablespoon of medicine likely to be administered a week from Tuesday, the Greenspan-led Federal Reserve seems to be trying to rein in the sky-high consumer sentiment that has been driving the economy.

But the medicine did not seem to be working Friday on bank stocks, which recouped much of the losses taken earlier in the week. The Standard & Poor's bank index rose 4.08%, outpacing the 1.71% rise in the Dow Jones Industrial average.

That may indicate that the Fed's job of restraining the market's exuberance will be more difficult, but it was only one day. Consumers' moods are tightly linked to the bull market in stocks of the past few years. That means the Fed's strategy carries risks and uncertainty, several economists pointed out. If public confidence drops too sharply, bringing stocks down with it, the impact on the economy could be dire. That is what Mr. Greenspan is trying to avoid.

The slump in equities since the Fed's initial rate hike on June 30 has apparently not yet frightened consumers. Overall consumer spending in July was stronger than many economists had anticipated, with auto sales leading the way.

In recent years consumers have been conditioned to expect nothing but good economic news, said Ian Shepherdson of High Frequency Economics in Valhalla, N.Y. That has helped send the nation's savings rate steadily deeper into negative territory.

In raising interest rates, the Fed's tactic is to make consumers think harder about running such large deficits, and to make it more difficult and expensive to finance them, Mr. Shepherdson said.

Until the mid-1990s that was the way consumers were affected by monetary policy, Mr. Shepherdson said. Higher interest rates had a direct impact on consumers' outlook, principally with regard to the housing and mortgage sector, and the savings rate rose as spending slowed, he said.

Today, however, consumer psychology is tied closely to the stock market, making the Fed's job more delicate and difficult.

In 1990, 50% of individuals' financial assets were in stocks and stock mutual funds. Now it's 73%, said A. Gary Shilling, a former chief economist at Merrill Lynch & Co. who now heads his own money management firm in Springfield, N.J.

Though two-thirds of Americans own their homes and thus are influenced positively by rising home values, the recent uptick in housing prices is probably driven by stock appreciation, both directly by making people feel wealthier and indirectly by boosting overall consumer spending, economic activity, and incomes, Mr. Shilling said.

Working from a statistical model that uses data from 1970 through 1998, the economist estimated that a 10% increase in stock prices substitutes for 0.22% in savings as a percentage of personal disposable income. Meanwhile, a 10% rise in housing prices reduces the savings rate by 0.71 percentage point.

On the other hand, for each percentage-point rise in the unemployment rate, the savings rate rises 0.41 point. And a one-point rise in the federal funds rate pushes up the savings rate by 0.19 point.

Given the strong market rebound after last year's deep slide, Mr. Shepherdson said, he would be very surprised if a modest increase in interest rates proved enough to hit stock prices sufficiently hard to change consumer behavior in any meaningful way.

He said that his own analysis, done earlier this year, suggests that to slow consumer spending growth by one percentage point in a year through a slide in stock prices, the Fed would have to induce roughly a 20% drop in the Standard & Poor's index.

Mr. Shepherdson said he doubted Fed policymakers have the stomach for that. But he said that Mr. Greenspan very likely would not feel bad if stock prices stagnated for a year or so. And even a sustained correction would not break his heart.

On the other hand, Mr. Shilling said, if history is any guide, the Fed will continue to raise rates until something happens.

Though an external shock like the Asian financial crisis could interrupt the Fed's credit-tightening regimen - that is what happened in 1997 after only one rate hike - the usual course is for rates to move upward until the prospect of recession appears, Mr. Shilling said.

Already, he said, the recent leap in mortgage rates is cramping housing activity, and a substantial bear market in stocks will kill consumer sentiment and spending.

Indeed, he said he expects that additional Fed action will sink the bull market and consumer expectations, setting the stage for a U.S. recession in 2000 with global ramifications. That would prompt the Fed to reverse policy.

Mr. Shilling's forecast beyond that is for a substantial drop in rates, with modest, 1% to 2% deflation in consumer-product prices, triggered by the next recession. That would require major adjustments by consumers, notably a reduction in debt, but Mr. Shilling said he thinks the declines would also set the stage for a period of robust economic growth.

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